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MF Global: The mess that keeps getting messier

November 21, 2011: 11:35 AM ET

As the questions and conflicts in the MF Global bankruptcy pile up, investors are pooling their resources to get a seat at the table.

By Leah McGrath Goodman, contributor

Jon Corzine

Jon Corzine: Nothing to smile about anymore

FORTUNE -- Big institutional investors are getting a taste of what many frustrated taxpayers experienced during the financial crisis: Being on the hook for losses of a major financial firm against their wishes.

This time, of course, it's MF Global at the center of the dispute. A once-trusted brokerage with roots dating back to the 1700s, MF Global is now a bankrupt firm suspected of misappropriating customer funds to the tune of at least $600 million.

More than two weeks after MF Global's Halloween bankruptcy filing, there are more questions than answers and a surfeit of conflicts in an investigation that should be aiming to restore the public's confidence, but is doing the opposite. On Monday, the bankruptcy trustee for the case announced that there may be much more than $600 million missing from MF Global accounts -- perhaps as much as $1.2 billion. Hundreds of millions of dollars of trading capital and collateral were frozen without notice, dramatically disrupting the derivatives marketplace and ushering in a phalanx of federal prosecutors, regulatory agencies and forensic accountants working around the clock to determine where the missing money is. This, after a lawyer for MF Global assured a New York judge earlier this month "there is no shortfall."

What's different about this case?  One hedge fund executive summed it up best: "What is scary about MF Global is that there is no political will in this country to look out for people. Let this be a lesson that, if someone tries to steal from you, there is no one who is going to save you. I mean it is literally the most frightening thing that can happen in finance."

Led by a sense of outrage -- as well as the conviction that if they don't look out for themselves, no one else will -- investors have been pooling information and banding together to defend themselves for weeks. The most prominent group has been the Commodity Customer Coalition, spearheaded by James Koutoulas, chief executive of Typhon Capital Management, who's representing a few thousand former MF Global clients. Traders have also taken to the blogosphere, including Andrew Abraham of Abraham Investment Management, who's written extensively about how investors have been ignored, refunded only partially and in lopsided fashion and ought to complain to officials in Washington.

It looks as though the pushback could finally be working: Thursday U.S. Bankruptcy Judge Martin Glenn approved a $520 million cash distribution to about 23,000 MF Global customers, which will take around a week to disburse.

Roads lead back to J.P. Morgan

But a list of contentious issues remains, and at the top is the missing money. While hundreds of millions of dollars have turned up in a custodial account at J.P. Morgan (JPM), none of those funds have been restored to MF Global clients, who should have been first in line to get them. Investors have been crying foul, and so they should. Customer accounts are supposed to be kept strictly segregated from a brokerage firm's money. According to the CME Group's (CME) Chicago Mercantile Exchange, the world's dominant futures market and the designated "self-regulatory organization" of MF Global, those rules were violated.

Although MF Global owes J.P. Morgan $1.2 billion as an unsecured creditor, clients of MF Global whose funds are still missing should not have to beg J.P. Morgan for relief. "We're simply asserting that if MF Global commingled funds from customer accounts, or cannot properly account for them, J.P. Morgan can't lay claim to those funds as if they were their own," Koutoulas has asserted. Already, trading volumes have taken a hit because investors have been deprived of their own capital, socked with margin calls, or found live trades in limbo. According to the bankruptcy trustee, more than 3 million positions with a notional value of $100 billion were left in the lurch.

The trustee, James Giddens of Hughes Hubbard & Reed LLC, tells Fortune he has begun an investigation into the MF Global funds held at J.P. Morgan, but he has not asked the bank to return the money, pending the outcome. A spokeswoman for J.P. Morgan confirmed the bank is holding the money and said it has no intention of releasing the funds while the investigation is ongoing.

"There is something that's a little wrong with this, isn't there? It seems the trustee should be looking out for us, demanding this money back and going to the judge," says an independent trader in New York still awaiting $1 million of his missing funds. "Why is J.P. Morgan holding it? I am not a creditor. This is my money." Giddens himself has a long history of doing work for J.P. Morgan, which not surprisingly voted in favor of appointing his law firm to the MF Global case (and the vote was not unanimous).

Corzine connection

The MF Global implosion is also fraught with questions about  the recently defrocked Jon Corzine, who resigned as MF Global's chief executive earlier this month. Corzine's background as a co-chairman at Goldman Sachs before he became Democratic New Jersey governor presents certain difficulties. For one, Gary Gensler, the head of the Commodity Futures Trading Commission – one of a handful of agencies investigating the MF Global disaster – previously worked with Corzine at Goldman Sachs (GS). As a result, he had to recuse himself from leading the probe. CFTC commissioner Jill Sommers has taken his place. While Sommers is a senior commissioner, this appointment shows Washington's continued disinterest in mounting a real crackdown, as Sommers is widely seen as friend to the futures industry and – in keeping with MF Global's conflict-of-interest quotient – a former employee of the CME.

The CME's own actions, it turns out, also are not above scrutiny, as a source privy to a non-public review of the MF Global scandal at the exchange reveals that red flags cropped up shortly before MF Global's collapse, but were not disclosed to the CFTC as they should have been. This would be a violation of the rules applying to the CME as a self-regulatory organization. "It's absurd that a self-regulating body can exist when it's a non-regulating body," the New York trader says. "This is a public exchange. Everyone is terrified." For its part, the CME has issued a statement saying that such reports have been filled with "inaccuracies."

Meanwhile, the CFTC, which is supposed to be the central watchdog agency of the futures market, can be thanked for relaxing the rules restricting how firms like MF Global use customer funds  when the customer's not using it – a privilege for which MF Global, among others, furiously lobbied for years. Late last week, reports trickled in from the MF Global probe that the firm may have unlawfully relaxed those rules ahead of its bankruptcy, using client funds to pay off its debts and bolstering the $6.3 billion bet on sovereign European debt that ultimately overturned the brokerage.

All of which means the money might not just be missing, it could be gone for good. While many large-sized traders believe that the tangles in the MF Global web will eventually be sorted out, that doesn't help the smaller investors who continue to suffer.

"We expected some hiccups, but it's been botched from the get-go," says Sean McGillivray of Great Pacific Wealth Management, an introducing brokerage that's attempting to advocate for its clients. "It's shut us down and it's effectively shut down tens of thousands of futures investors and their supporting brokerages. I try to reach the trustee every day. Once I got voicemail. But usually it rings off the hook."

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